Is a reduction in interest rates justified in a milieu of high fiscal deficit? The gross fiscal deficit of the Centre (as a proportion of the GDP) averaged 6.56 per cent during the five years ended 1994-95; the average slipped to 5.5 per cent in the second half of the nineties. That is not much of a reduction. Indeed, the Reserve Bank feels that the government is making too large a draft on financial savings. Thus, the context is one in which interest rates should harden.

The Reserve Bank prevented this by successively lowering the banks CRR. The consequent injections of liquidity somewhat offset the impact of the heavy fiscal deficit (covered by market borrowings). But the more important source of liquidity was the rapid rise in foreign currency assets after 1995-96: these rose from $17.4 billion to $35 billion in 1999-2000. This increase required foreign currency purchases by the Reserve Bank. The rupees paid for the acquisition added to liquidity.

This enabled the Reserve Bank to accommodate the government's large borrowing programme and to simultaneously keep interest rates stable.

Post-1995-96, the demand for bank credit was slack; it rose in 1999-2000. But the Reserve Bank wanted to lower interest rates. It got the banks to reduce interest rates on deposits; and the government to cut down the interest on small savings. Then came its April coup de grace.

There is no evidence of a rise in financial savings; nor of a reduction in the draft the government makes on these savings to cover its large fiscal deficit (5.1 per cent of the GDP is the budget estimate for 2000-2001). But the Reserve Bank was counting on the liquidity flush (mainly in the second half) of 1999-2000, when foreign currency reserves rose by $5.5 billion to cover the fiscal deficit and to give a push to private borrowings at reduced interest rates.

You can dampen investment with high interest rates. But can you quicken investment with lower interest rates in a situation of declining public investment (which depresses aggregate demand)? April-June did not see a surge in private investment intentions. At softened interest rates government paper did not attract much investment. (Revolt against the low interest rates regime?) The liquidity surplus went into speculation, perhaps in anticipation of a rise in import demand.

Speculation could also have been triggered by the over-dependence of government and private credit on liquidity stemming from foreign currency inflows; the Reserve Bank's April strategy relied on foreign savings, and gave domestic savings the short shrift. The implicit demand for foreign currency rose. The price of foreign currency had to go up. With its back to the wall, after the July policy reversal, the Reserve Bank is rolling back excess liquidity at high (repos) interest rates.